FinEval Module 1

FINANCIAL EVALUATION AND
STRATEGY: INVESTMENTS
with Scott Weisbenner
MODULE 1
Investments Toolkit and
Portfolio Formation
LESSON 1 - 1
Objectives and Overview
VIDEO 1 - 1
Objectives and Overview
QUICK QUESTION
How many recordings did it take

before SCOTT made the basket?
(A) Made it on the first attempt!
(B) Second attempt
(C) Third attempt
(D) Fourth attempt
(E) Too many to count
(F) None video was doctored!
S C O T T W EIS B EN N E R , C OL L E GE OF B U S IN E SS , U N IV E R SIT Y O F IL L IN O IS A T U R BA N A -C H A MP AIG N
HOW DO YOU BUILD A TEAM?
Image from NewsLocker

2003-04 LOS ANGELES

LAKERS
Assembled a team of all-time
greats
Kobe Bryant
17-time All Star
1 Most Valuable Player Award
Shaquille ONeal
15-time All Star
1 Most Valuable Player Award
2003-04 LOS ANGELES

LAKERS
Assembled a team of all-time
greats
Karl Malone
14-time All Star
2 Most Valuable Player Awards
Gary Payton
9-time All Star
HOW DO YOU BUILD A TEAM?
Dave Hogg, Flickr, CC BY 2.0

2003-04 DETROIT
PISTONS
Assembled a team of players
who knew their roles
Starting five players have 16 All-
Star appearances and 0 MVP
awards among them
Compared to 55 combined All-Star
appearances and 4 MVPs for the
Lakers top 4 players
PISTONS WIN THE NBA FINALS:

4 GAMES TO 1!
White House Press Secretary office,

Wikimedia Commons, CC0 Public
Domain
LIKE PUTTING TOGETHER THE

OPTIMAL PORTFOLIO!
White House Press Secretary office,

Wikimedia Commons, CC0 Public
Domain
LESSON FOR
INVESTMENTS
When constructing a portfolio,
dont just care about expected
returns of assets.
Care a lot about how the
assets in the portfolio
correlate with each other.
Also, past performance is not
a guarantee of future
performance!
MODULE 1 OVERVIEW
Lesson 1-1 Objectives and

Overview
Lesson 1-2 Investments Toolkit
Lesson 1-3 Historical Returns in
the U.S.
MODULE 1 OVERVIEW
Lesson 1-4 Return and Risk:
Intro to Portfolios
Lesson 1-5 Portfolio Choice in
General Settings
Lesson 1-6 Assignment 1 &
Discussion:
Portfolio Choice When Change
Correlations
MODULE 1 OVERVIEW
Lesson 1-7 Calculating Efficient

Portfolios of Risky Assets
Lesson 1-8 Assignment 2 &
Discussion: Calculating More
Efficient Portfolios
Lesson 1-9 Module 1 Review
HIGH-ENGAGEMENT
ACTIVITY
Further practice on
optimal/efficient portfolio
formation: Completion and
discussion of Partners
Healthcare case study
Explore whether this organization
should change its asset mix to
include Real Estate Investment
Trusts (REITs) and Commodities
MY VIEW ON MODULE 1
OF THE COURSE
Mallory Dash, Flickr, CC BY-ND 2.0

WITHOUT MODULE 1
J.smith, Wikimedia Commons, CC BY-SA 3.0

PRACTICAL
KNOWLEDGE / EXPERIENCES
Historical returns in the U.S.
How to form a portfolio of
securities and calculate the
return and risk of that portfolio
(standard deviation or volatility)
PRACTICAL
KNOWLEDGE / EXPERIENCES
How to graph return-volatility
tradeoffs and construct
optimal/efficient portfolios
Whether it makes sense to hold
gold
Benefit of adding international
funds to a U.S. large-stock fund
REFERENCES
Russell Valenzuela. 2004. Lakers news: Kobe Bryant, Shaquille ONeal discuss 2004 off-season
breakup. Retrieved from http://www.newslocker.com/en-us/sport/los-angeles-lakers/lakers-news-
kobe-bryant-shaquille-oneal-discuss-2004-off-season-breakup/view/
Dave Hogg. 2005. The real fab five. Retrieved from
https://www.flickr.com/photos/davehogg/77257679/
White House Press Secretary Office. 2005. 2004 Detroit Pistons congratulated by George Bush.
Retrieved from
https://commons.wikimedia.org/wiki/File:2004_Detroit_Pistons_congratulated_by_George_Bush.jpg
Mallory Dash. 2011. Fresh Broccoli. Retrieved from
https://www.flickr.com/photos/39975765@N05/5487249267
J.smith. 2004. House for Sale, damaged. Retrieved from
http://commons.wikimedia.org/wiki/File:House_for_Sale,_damaged.JPG

MODULE 1
Portfolio Formation
LESSON 1 - 2
Investments Toolkit
VIDEO 1 - 2.1
Objectives and Assumptions of Classical Finance
INVESTMENTS TOOLKIT
Minnesota Historical Society, Flickr, CC BY-SA 2.0

LESSON 1-2
OBJECTIVES
You will understand:

Why Discount?
Different Return Measures
LESSON 1-2
OBJECTIVES
Firm Characteristics Relevant for
Investments
Zero-Cost Portfolio (long-short
strategies)
Statistical Techniques and Excel
ASSUMPTIONS OF
CLASSICAL FINANCE
Investors prefer more to less
Investors are risk averse
Money paid in the future is worth
less than the same amount today
Financial markets are
competitive: no arbitrage
opportunities
REFERENCES
Minnesota Historical Society. 2012. Minnesota State Capitol Woodworkers Toolbox, circa
1900. Retrieved from
https://www.flickr.com/photos/minnesotahistoricalsociety/5494632378/sizes/l/in/photostream/

MODULE 1
Portfolio Formation
LESSON 1 - 2
Investments Toolkit
VIDEO 1 - 2.2
Why Discount?
LESSON 1-2 OBJECTIVES

Why Discount?
Investments
strategies)
Statistical Techniques & Excel
WHY DISCOUNT
FUTURE CASH FLOWS?
Cash flows tomorrow worth

less than today
Discount rate
Time value of money
Riskiness of cash flows
PAUSE, THINK, AND

ANSWER!
Yair Haklai, Wikimedia Commons, CC BY-SA 3.0

PAUSE, THINK, AND

ANSWER!
What is the future value of
$200 invested for two years at
an annual rate of 10% (paid at
the end of the year)?
FUTURE VALUE: MULTIPLE PERIODS
What is the future value of $200 invested for two years at an

annual rate of 10% (paid at the end of the year)?
FV = future value
PV = present value
General formula: FV = PV * (1+r)n
Or, rearranging: PV = FV / (1+r)n
FUTURE VALUE: MULTIPLE PERIODS
What is the future value of $200 invested for two years at an

annual rate of 10% (paid at the end of the year)?
FV = PV(1+r)(1+r) = 200(1.10)2 = 242
FV= 200+2(10%)200+10%(10%)200 = 200+40+2
FV = Principal + simple interest + compound interest
A VERY PAINFUL
SURVEY QUESTION!
If you have $200 in a savings account that
earns 10% interest per year, compounded
yearly:
How much do you believe you would have in
the account at the end of two years, assuming
you make no additional deposits or
withdrawals?
Source: Jeffrey R. Brown and Scott Weisbenner, 2014

PEOPLE REALLY HATE

MATH: BAD FOR FINANCE!
AP-AOL poll: Almost 40% of

adults hated math in school
(twice as many as the next most
unpopular subject)
Source: redorbit.com
PEOPLE REALLY HATE

MATH: BAD FOR FINANCE!
Headline:
We hate Math, say 4 in 10

a majority of Americans
WASHINGTONPeople in this country have a love-hate
relationship with math, a favorite school subject for some
but just a bad memory for many others, especially women.
In an AP-AOL News poll as students head back to school,
almost four in 10 adults surveyed said they hated math in
school, a widespread disdain that complicates efforts today
Headline from redorbit.com

WHY HATING MATH

MATTERS!
Most important factor in
finance:
Power of compound interest
WHY HATING MATH MATTERS!
Lets say $1,000 is saved for either 1, 2, 5, 10, 20, or 30 years

at a 10% rate of return per year.
Over those various horizons, how much of the final wealth is
comprised of the original balance, simple interest, and the
compounding interest?
WHY HATING MATH MATTERS!

Lets say $1,000 is saved at a 10% rate of return per year for
either 1, 2, 5, 10, 20, or 30 years.
Composition of wealth accumulation (in thousands of $):
Compound interest
Simple interest
Original balance
Wealth at the end
1 year
2 years
5 years
10 years
20 years
30 years
0.01
0.11
0.59
3.73
13.45
0.1
0.2
0.5
1.10
1.21
1.61
2.59
6.73
17.45
PAUSE, THINK, AND

ANSWER!

QUESTION 1:
CONVERT FUTURE TO
PRESENT
Suppose you are going to be
paid $50,000 three years from
now.
What is that worth today if
interest rates are 2%?
QUESTION 2: CONVERT
FUTURE TO PRESENT
What if interest rates go up to
5%? Do you expect the value
today to go up or down
relative to when interest rates
were 2%?
What is the new present value
when interest rates are 5%?
ANSWER 1: CONVERT
FUTURE TO PRESENT
Suppose you are going to be
paid $50,000 three years from
now.
What is that worth today if
interest rates are 2%?
ANSWER 2: CONVERT
FUTURE TO PRESENT
What if interest rates go up to
5%? Do you expect the value
today to go up or down
relative to when interest rates
were 2%?
What is the new present value
when interest rates are 5%?
REFERENCES
Yair Haklai. 2012. Le Penseur at the California Palace of the Legion of Honor. Retrieved
from http://commons.wikimedia.org/wiki/File:Auguste_Rodin-The_Thinker-Legion_of_Honor-
Lincoln_Park-San_Francisco.jpgRetrieved from
http://commons.wikimedia.org/wiki/File:Auguste_Rodin-The_Thinker-Legion_of_Honor-
Lincoln_Park-San_Francisco.jpg
Jeffrey R. Brown and Scott Weisbenner, 2014, Why do individuals choose defined
contribution plans? Evidence from participants in a large public plan, (with Jeffrey R.
Brown), Journal of Public Economics, Vol. 116, p. 35-46.
Redorbit. Americans Love to Hate Math, Poll Shows. 2005. Retrieved from
http://www.redorbit.com/news/education/211362/americans_love_to_hate_math_poll_shows/

MODULE 1
Portfolio Formation
LESSON 1 - 2
Investments Toolkit
VIDEO 1 - 2.3

Why Discount?
Investments
strategies)
WHAT WE MEAN BY RETURN

The return of a security or asset is the change in price plus any
cash payout received normalized by the beginning-of-period price.
Returnt = (Pricet - Pricet-1 + Dividendt) / Pricet-1
Returns are calculated over many horizons
ARITHMETIC AVERAGE RETURN
Arithmetic average =
1
( r1 + r2 + r3 + ... + rn )
n
Useful for forecasting the return next period based on past experience
GEOMETRIC AVERAGE RETURN
Geometric average =
1/ n
[(1 + r1 )(1 + r2 )(1 + r3 )...(1 + rn )]
1n
V (n)
=
1
V (0)
Gives the equivalent per-period return (useful for buy-and-hold investors)
EXAMPLE
Suppose the return for an emerging markets fund

in Year 1 is 100% and -50% in Year 2.
Arithmetic average of returns
(100% + -50%) / 2 = 25%
Geometric average of returns

$100 invested grows to 100(1+1.00)(1-0.50) = 100
Geometric average: [(1+1.00)(1-0.50)]1/2 - 1 = 0%
EXAMPLE
Suppose the return for an
emerging markets fund in Year 1
is 100% and -50% in Year 2.
Without reinvesting gains/losses,
the investor would have gained
$100 in Year 1 and lost $50 in
Year 2, or $50 total over two years.
This 25% return is the arithmetic
average.
EXAMPLE
Suppose the return for an
emerging markets fund in
Year 1 is 100% and -50% in
Year 2.
With a buy-and-hold strategy,
portfolio value is unchanged
after 2 years, equivalent to a
0% return per year.
This is the geometric average.
ANOTHER EXAMPLE TOO CLOSE TO HOME

Value of $1 Invested in US Stock Market at the end of 1999
1.3
1.2
1.1
1
0.9
0.8
0.7
0.6
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2000-2009: Average annual return to US stock market was 1.8% per year
1.8% annual return compounded over 10 years is 20%
$1 invested in US stock market in 2000 was $0.956 at the end of 2009 (NOT $1.20)
Geometric average of -0.44% per year
Data based on Kenneth R. French Data Library
ARITHMETIC VS.
GEOMETRIC AVERAGES
Geometric average: lower

than arithmetic average
Difference increases w/ volatility
of returns
ARITHMETIC VS.
GEOMETRIC AVERAGES
Arithmetic average:
unbiased estimate of future
returns of the same horizon
given past experience
(assuming same return
generating process going
forward)
EXCESS RETURNS
Excess return typically

means a return in excess of
the risk-free rate
Can also compare returns to
some other benchmark
Well spend a lot of time coming
up with this appropriate
benchmark!
REFERENCES
Kenneth R. French. 2015. Kenneth R. French Data Library returns from stocks and US
Treasury Bills. Retrieved from
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

MODULE 1
Portfolio Formation
LESSON 1 - 2
Investments Toolkit
VIDEO 1 - 2.4
Firm Characteristics Relevant for Investments

Why Discount?
Firm Characteristics Relevant
for Investments
strategies)
KEY FIRM
CHARACTERISTICS
FOR INVESTMENTS
Size
Book-to-market ratio
Momentum
Industry
SIZE
Measured as market value

(market cap) of common
stock outstanding
A key classification of firms
(e.g., small vs. large)
PAUSE, THINK, AND

ANSWER!

QUESTION: FIRM SIZE
How do firms of different sizes

weather economic
downturns?
How else do stocks of small-
cap and large-cap stocks
differ?
ANSWER: FIRM SIZE
How do firms of different sizes

weather economic
downturns?
How else do stocks of small-
cap and large-cap stocks
differ?
BOOK-TO-MARKET
RATIO
Measured by book value of
firm equity (from balance
sheet) relative to market
value of equity
In corporate finance, use
market-to-book ratio.
Beware! Meaning is in the

eye of the beholder!
PAUSE, THINK, AND

ANSWER!

QUESTION: BOOK-TO-
MARKET RATIO
How do you interpret
differences in book-to-market
ratios across firms?
Why do some firms have high
book-to-market ratios and
others have low book-to-
market ratios?
ANSWER: BOOK-TO-
MARKET RATIO
How do you interpret
differences in book-to-market
ratios across firms?
Why do some firms have high
book-to-market ratios and
others have low book-to-
market ratios?
MOMENTUM
Performance of a firm over

the past year seems to predict
the firms stock return over the
next month (both positively
and negatively).
STAY TUNED TO MODULE 3
REFERENCES

MODULE 1
Portfolio Formation
LESSON 1 - 2
Investments Toolkit
VIDEO 1 - 2.5
Zero-Cost Portfolio (long-short strategies)

Why Discount?
Investments
strategies)
WILL OCCASIONALLY
EXAMINE ZERO-COST
PORTFOLIOS
Suppose we know within a
certain group of stocks that
some will do better than
others.
Can you form a portfolio where
you benefit both from the good
performers as well as the bad
performers?
EXAMPLE: TOYOTA-GM
Expect Toyota to perform
better than GM
Zero-cost portfolio:
Long Toyota stock
Short GM stock
Note: This simple example

ignores margin requirements!
EXAMPLE: TOYOTA-GM
Implementation of zero-cost,
long-short strategy of Toyota-
GM (1-year strategy)
Borrow $1 of GM stock
Sell GM and take the $1 to invest
in Toyota
One year later, sell your Toyota
stock and then take the proceeds
to buy back and return the stock
of GM you borrowed
EXAMPLE: TOYOTA-GM
Return = rToyota rGM

No money up front (excluding
margin requirement!)
This strategy is long Toyota
and short GM
EXAMPLE: TOYOTA-GM
EXAMPLE: TOYOTA-GM

MODULE 1
Portfolio Formation
LESSON 1 - 2
Investments Toolkit
VIDEO 1 - 2.6

Why Discount?
Investments
strategies)
STATISTICAL
TECHNIQUES
USED IN COURSE
Averages (and differences in
averages) of portfolio returns
Linear regression models
Regression output
Coefficient estimates and their
statistical and economic
significance
R-squared of the regression
EXCEL ADD-INS
USED IN COURSE
Will use Excel as spreadsheet

program
Will use these Add-Ins in
Excel:
Data Analysis (regression)
Solver (optimizer)
STEP 1: ADDING EXCEL ADD-INS
RESULT 1: ADDING EXCEL ADD-INS

MODULE 1
Portfolio Formation
LESSON 1 - 2
Investments Toolkit
VIDEO 1 - 2.7
What Weve Learned
WHAT WEVE LEARNED

IN LESSON 1-2
Assumptions of Classical
Finance
Risk aversion, discounting, no
arbitrage
Why Discount
Time cost of money and some
notion of riskiness of cash flows
WHAT WEVE LEARNED

IN LESSON 1-2
Arithmetic vs. Geometric returns
Excess return of asset usually
means excess of some risk-free rate

Investments
Size & Value/Growth: key for this
course
Momentum strategy
WHAT WEVE LEARNED

IN LESSON 1-2
strategies)
Way to exploit both positive and
negative expectations

Be familiar with basic regression
analysis!

MODULE 1
Portfolio Formation
LESSON 1 - 3
Historical Returns in the U.S.
VIDEO 1 - 3
Historical Returns in the U.S.

Distribution of historical returns for
various asset classes in the U.S.
Magnitude of the equity premium in
the past and why its important
FIRST, SOME PERSPECTIVE FROM MARK TWAIN
Get your facts first, then you can

distort them as you please.
We will examine historical returns of
various securities.
A.F. Bradley, Wikimedia Commons, CC0 Public Domain

FIRST, SOME PERSPECTIVE FROM MARK TWAIN
Are these return patterns

reasonable?
Will historical return patterns
continue?
This is where the debate begins!
A.F. Bradley, Wikimedia Commons, CC0 Public Domain
HISTORICAL
RETURNS
Look for return-risk relation
across asset classes based on
realized returns
Whats past is prologue?
One of the biggest issues: size of
equity premium going forward
Very important for projecting
hurdle/discount rates for firms
ANNUAL RETURNS (1927-2014)
Arithmetic Average
Standard Deviation
U.S. Treasury Bills (1 month)
3.5%
3.1%
U.S. Treasury Bonds (10 year)
5.3%
7.8%
U.S. Stock Market (value-weighted)
11.9%
20.4%
Small U.S. Stocks (bottom decile)
19.0%
39.4%
Data based on Kenneth R. French Data Library & Aswath Damodaran Online Data
128
64
32
16
8
4
2
1
$70
$20
1926
1930
1934
1938
1942
1946
1950
1954
1958
1962
1966
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
2010
2014
Value of $1 Invested in
Asset End of 1926
VALUE OF ASSET FOLLOWING $1 INITIAL

INVESTMENT (USING ANNUAL RETURNS)
10-Year US Treasury Bonds
Treasury Bills
8192
2048
512
128
32
8
2
0.5
$3,994
$70
$20
1926
1930
1934
1938
1942
1946
1950
1954
1958
1962
1966
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
2010
2014
Asset end of 1926

US Stock Market
Treasury Bills
65536
8192
1024
128
16
2
0.25
$39,245
$3,994
$70
$20
1926
1930
1934
1938
1942
1946
1950
1954
1958
1962
1966
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
2010
2014
Asset end of 1926

Small Stocks
US Stock Market
Treasury Bills
PAUSE, THINK, AND

ANSWER!

QUESTION 1: WHY ARE

THERE DIFFERENCES
IN RETURNS?
Why do we see these
differences across asset
classes?
Why is the average return of
Treasury bills less than 10-
year treasuries less than
stock market less than small
stocks?
QUESTION 2:
ARITHMETIC VS.
GEOMETRIC
Which asset class will have
the smallest difference
between arithmetic and
geometric returns? Why?
the biggest difference
ANSWER 1: WHY ARE

THERE DIFFERENCES
IN RETURNS?
Why do we see these
differences across asset
classes?
Why is the average return of
Treasury bills less than 10-
year treasuries less than
stock market less than small
stocks?
ANSWER 2:
ARITHMETIC VS.
GEOMETRIC
the smallest difference
the biggest difference
Arithmetic Average
Geometric Average
3.5%
3.5%
5.3%
5.0%
11.9%
9.9%
19.0%
12.8%
Annual Returns (in %)
1927-2014: OVERALL STOCK MARKET VS.

TREASURY BILLS
60
50
40
30
20
10
0
-10
-20
-30
-40
-50
-60
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
2020

Annual Returns (in %)

SMALL STOCKS
160
140
120
100
80
60
40
20
0
-20
-40
-60
1920
1930
1940
1950
US Stock Market
1960
1970
1980
1990
2000
2010
2020
US Small Stocks (bottom decile)

DISTRIBUTION OF ANNUAL
RETURNS IN % (1927-2014)
5th
25th
50th
75th
95th
>0?
U.S. Treasury Bills

(1 month)
0.0
0.8
3.1
5.2
9.9
0.98
U.S. Treasury Bonds

(10 year)
-5.0
0.9
3.6
8.8
20.1
0.82
U.S. Stock Market

(value-weighted)
-27.7
-9.0
14.9
27.6
39.0
0.75
Small U.S. Stocks

(bottom decile)
-43.7
-6.0
17.8
40.0
92
0.65
EQUITY MARKET PREMIUM (1927-2014)

Average Annual Equity Market Premium = 8.4%
Equity Market Premium

(Stock Market minus T-bills)
5th
25th
50th
75th
95th
>0?
-31.2
-6.3
10.7
22.9
38.4
0.69
Will it continue???
WHY DOES EQUITY

PREMIUM MATTER?
Corporate Finance perspective

Investment Management
perspective
WHAT WEVE LEARNED

IN LESSON 1-3
U.S. stock market has
averaged about 12% per year
U.S. Treasury bills have
averaged 3.5% per year
Leading to an equity premium
around 8% per year
WHAT WEVE LEARNED

IN LESSON 1-3
A portfolio of the smallest
stocks (bottom decile by
market capitalization)
averages an annual
return of 19% per year
But these stocks are more
volatile than the stock
market as a whole
WHAT WEVE LEARNED

IN LESSON 1-3
The future equity market is
important for projecting firms
hurdle rates or required returns,
as well as constructing
investment portfolios.
STAY TUNED
REFERENCES
A.F. Bradley. 1907. Mark Twain. Retrieved from
http://commons.wikimedia.org/wiki/File:Mark_Twain_by_AF_Bradley.jpg
Aswath Damodaran Online Data for returns from 10-year US Treasury bonds Retrieved from
http://www.stern.nyu.edu/~adamodar/pc/datasets/histretSP.xls

MODULE 1
Portfolio Formation
LESSON 1 - 4
Return and Risk:
Intro to Portfolios
VIDEO 1 - 4
Return and Risk:
Intro to Portfolios

SUSHI & FORECLOSURES and how
they can work well together!
How to calculate expected portfolio
returns and standard deviations
How asset combinations (i.e., portfolio
weights) affect portfolio risk
STATISTICS OF RETURNS
Average (Arithmetic)
E (R ) = pn Rn
N
Variance
VAR ( R) = pn "# Rn E ( Rn )$%

N
Standard Deviation
= VAR(R)
Covariance
COV (R1 , R2 ) = pn [R1,n E (R1,n )][R2,n E (R2,n )]

N
Correlation Coefficient
1,2 =
COV (R1, R2 )
1 2
CONSIDER 2 STOCKS AND 2 STATES

OF THE WORLD
World: Either in a GOOD or BAD state
Stocks: Rare Sushi, Inc. & Foreclosures R Us
State of
World
Probability of
State
Rare Sushi
Return
Foreclosures
Return
Good
0.80
20%
-5%
Bad
0.20
-20%
80%
CALCULATING
STATISTICS OF STOCK
RETURNS
What is the average return
and the standard deviation of
Rare Sushi, Inc. and
Foreclosures R US?
Round answers to the nearest
tenth of a percentage point (e.g.,
5.1%)
CONSIDER 2 STOCKS AND 2 STATES

OF THE WORLD
World: Either in a GOOD or BAD state
Stocks: Rare Sushi, Inc. & Foreclosures R Us
State of
World
Probability of
State
Rare Sushi
Return
Foreclosures
Return
Good
0.80
20%
-5%
Bad
0.20
-20%
80%
RARE SUSHI, INC.

Average Return
Standard Deviation
PAUSE, THINK, AND

ANSWER!

QUESTION:
CALCULATING
STATISTICS OF STOCK
RETURNS
Foreclosures R Us
Average Return
Standard Deviation
ANSWER:
FORECLOSURES R US
Average Return
Standard Deviation
CALCULATING A CORRELATION
Is the correlation between Rare Sushi, Inc. & Foreclosures R Us
positive or negative? What is the correlation between the two?
State of
World
Probability of
State
Rare Sushi
Return
Foreclosures
Return
Good
0.80
20%
-5%
Bad
0.20
-20%
80%
CALCULATING A CORRELATION
State of
World
Probability of
State
Rare Sushi
Return
Foreclosures
Return
Good
0.80
20%
-5%
Bad
0.20
-20%
80%
WE CAN DO BETTER RETURN OF A PORTFOLIO

The return of a portfolio is the weighted average of the return of
its components:
P
r!
Return of
Portfolio
w
!
r!
Weight in Return of
Asset A Asset A
w
!
r!
Weight in Return of
Asset B Asset B
The weights are determined by the proportion invested in the

components:
Dollar Value of Asset A in Portfolio
A
w
=
Total Dollar Value of Portfolio

Weight in
Asset A
RETURN AND
STANDARD DEVIATION
OF PORTFOLIO
Your portfolio:
50% invested in Rare Sushi, Inc.
50% invested in Foreclosures R Us
What are the expected return

this portfolio?
EXAMINE A 50/50 PORTFOLIO

Lets calculate the return on a 50/50 portfolio across the GOOD
and BAD states of the world.
State of
World
Probability of
State
Rare Sushi
Return
Foreclosures
Return
Good
0.80
20%
-5%
Bad
0.20
-20%
80%
Now we can calculate the average and standard deviation of the

50/50 portfolio.
RETURN AND
STANDARD DEVIATION
OF PORTFOLIO
Expected return of portfolio:
RETURN AND
STANDARD DEVIATION
OF PORTFOLIO
Standard deviation of
portfolio:
PAUSE, THINK, AND

ANSWER!

QUESTION: PORTFOLIO
RETURN AND RISK
New portfolio:
What are the expected return and

the standard deviation?
ANSWER: PORTFOLIO
RETURN AND RISK
New portfolio:
What are the expected return and

the standard deviation?
REALIZED AND EXPECTED RETURNS OF

PORTFOLIO
Realized/actual return:
N
rp = wi ri = w1r1 + ... + wN rN
i =1
Expected return:
N
E (rp ) = wi E (ri )
i =1
VARIANCE OF A PORTFOLIO
With 2 assets (N=2):
Var[rp ] = p2 = w12 12 + w22 22 + 2w1w2 12 1 2

With N assets:
N
Var [ rp ] = p2 = wi2 i2 + 2 wi w j ij i j
i =1
i =1 j >i
p = p2
KEY INSIGHT ABOUT VARIANCE OF A

PORTFOLIO
N
Var[rp ] = p2 = wi2 i2 +2 wi w j ij i j
i =1
i =1 j >i
When a portfolio is made up of different stocks, the variability

of the return will depend on the correlation between the
various assets.
PAUSE, THINK, AND

ANSWER!

QUESTION 1: VARIANCE OF A PORTFOLIO
2
p
2
i
2
i
Var[rp ] = = w +2 wi w j ij i j
i =1
i =1 j >i
If all the various portfolio components are long (i.e., wi > 0), will a
higher correlation between assets (i.e., ij) lead to a higher or lower
portfolio variance?
QUESTION 2: VARIANCE OF A PORTFOLIO
2
p
2
i
2
i
i =1
i =1 j >i
What if you are long one asset (i.e., wi > 0) and short another
asset (i.e., wj < 0)? Does portfolio variance increase or decrease
when these two assets are more highly correlated with each other?
ANSWER 1: VARIANCE OF A PORTFOLIO

2
p
2
i
2
i
i =1
i =1 j >i
If all the various portfolio components are long (i.e., wi > 0), will a
higher correlation between assets (i.e., ij) lead to a higher or lower
portfolio variance?
ANSWER 2: VARIANCE OF A PORTFOLIO

2
p
2
i
2
i
i =1
i =1 j >i
What if you are long one asset (i.e., wi > 0) and short another
asset (i.e., wj < 0)? Does portfolio variance increase or decrease
when these two assets are more highly correlated with each other?
WHAT WEVE LEARNED

IN LESSON 1-4
We can calculate expected portfolio
returns and standard deviations!
Lets mainly use Excel in the future!
The expected return of a portfolio:

weighted average expected return of
the assets
A key component of portfolio
variance: correlation between the
assets
REFERENCES

MODULE 1
Portfolio Formation
LESSON 1 - 5
Portfolio Choice in General Settings
VIDEO 1 - 5.1
Objectives and Source of Data for Examples
LESSON 1-5
OBJECTIVES
Two examples of asset allocation
One risky asset and one risk-free asset
Two risky assets
The reward-to-volatility tradeoff in each

example
How to identify optimal/efficient
portfolios & dominated portfolios
SOURCE OF DATA FOR

EXAMPLES
Return-Volatility charts and key
portfolios presented in this lecture
are generated from data in these
two Excel files:
Return-Volatility-EXAMPLES.xlsx
EfficientFrontier-
LargeSmallExample.xlsx

MODULE 1
Portfolio Formation
LESSON 1 - 5
VIDEO 1 - 5.2
Asset Allocation with one Risky and
one Risk-free Asset
EXAMPLE 1:
ASSET ALLOCATION
WITH
ONE RISKY ASSET &
ONE RISK-FREE ASSET
PORTFOLIO OF RISKY
ASSET AND RISK-FREE
ASSET
Risky asset: LARGE stocks
Risk-free asset: Treasury bills
a portfolio that invests w in
LARGE stocks and (1-w) in
the risk-free asset?
PORTFOLIO OF RISKY
ASSET AND RISK-FREE
ASSET: ASSUMPTIONS
LARGE Stocks
Mean Return: 8%
Standard Deviation: 25%
Treasury Bills (Risk-Free Asset)

Mean Return: 3%
Zero correlation between the two

SOURCE OF DATA FOR

EXAMPLES
two Excel files:
EfficientFrontier-
REWARD-VOLATILITY TRADEOFF
Realized/actual return:
rP = w * rL + (1 w)* rRF
Expected return:
E(rP ) = w * E(rL ) + (1 w)* E(rRF )

REWARD-VOLATILITY TRADEOFF
Variance:
VAR (rP ) = VAR (( w) * rL + (1 w) * rRF )

2
2
(
)
(
)
(
)
= w *VAR rL + 1 w *VAR (rRF ) +
2 w * (1 w)* COV (rL , rRF )
VARIANCE AND STANDARD DEVIATION

(IN THIS SPECIFIC CASE)
Variance simplifies to:
2
Var (rP ) = (w ) *Var (rL )

Standard deviation simplifies to:
StdDeviation(rP ) = w * StdDeviation(rL )
Average Portfolio
Return (in %)
CAPITAL ALLOCATION LINE

(ASSUME NO BORROWING)
10
8
100%
LARGE
STOCKS
6
4
100% RF
2
0
0
5
10
15
20
25
Portfolio Standard Deviation (in %)
30
Slope represents a reward-to-volatility ratio:

Sharpe Ratio
SHARPE RATIO
The average excess return of an asset (in excess of the

risk-free rate) divided by the standard deviation of the
assets returns is a reward-to-volatility or Sharpe Ratio:
Sharpe Ratioi =
E[ri ] rf
SHARPE RATIO FOR LARGE STOCKS

In this example, what is the Sharpe Ratio for LARGE
stocks?
PAUSE, THINK, AND

ANSWER!

QUESTION: A HIGH-RISK ALLOCATION
Suppose we borrow at 3% rate

Portfolio is 200% LARGE Stocks and -100% Treasury Bills
(i.e., w = 2 and [1-w] = -1)
What is the average portfolio return and portfolio standard

deviation in this case?
Round to the nearest 1/10 of a percentage point (e.g., 5.1%)
ANSWER: A HIGH-RISK ALLOCATION
Suppose we borrow at 3% rate

Portfolio is 200% LARGE Stocks and -100% Treasury Bills
(i.e., w = 2 and [1-w] = -1)
What is the average portfolio return and portfolio standard

deviation in this case?
Round to the nearest 1/10 of a percentage point (e.g., 5.1%)
ANSWER: A HIGH-RISK ALLOCATION
Average Portfolio
Return (%)
CAPITAL ALLOCATION LINE (WITH BORROWING!)

14
12
10
8
6
4
2
0
LARGE
Stocks
200%
LARGE
Stocks,
-100% RF
10 15 20 25 30 35 40 45
Portfolio Standard Deviation (in %)
50
55
Borrowing at a 3% rate can achieve higher possible returns

But also leads to higher variability in returns
ASSET ALLOCATION DECISIONS
Portfolio choice between the risky asset and the risk-free asset
[i.e., the choice of w and (1-w)] depends on the risk attitudes of
the investor:
Risk-averse investors will invest a lot in Treasury bills.
Risk-loving investors will invest much more in stocks; may even borrow
(short the risk-free asset) to invest more in stocks!
REFERENCES

MODULE 1
Portfolio Formation
LESSON 1 - 5
VIDEO 1 - 5.3
Asset Allocation with Two Risky Assets
EXAMPLE 2:
ASSET ALLOCATION
WITH
TWO RISKY ASSETS
PORTFOLIO OF TWO
RISKY ASSETS
Risky assets: Both LARGE &
SMALL stocks
a portfolio that invests w in
LARGE stocks and (1-w) in
SMALL stocks?
PORTFOLIO OF TWO
RISKY ASSETS:
ASSUMPTIONS
Large Stocks
Mean Return: 8%
Small Stocks
Mean Return: 15%
Correlation between the two: 0.4

SOURCE OF DATA FOR

EXAMPLES
two Excel files:
EfficientFrontier-
Average Portfolio Return (%)
PORTFOLIO FRONTIER WITH TWO RISKY ASSETS

20
18
16
14
12
10
8
6
4
2
0
SMALL
Stocks
171%
SMALL
Stocks,
-71%
LARGE
Stocks
LARGE
Stocks
10
20
30
40
50
60
Portfolio Standard Deviation (%)
70
80
PAUSE, THINK, AND

ANSWER!

Q: WHAT IS THE FRONTIER IF CANNOT SHORT?

20
18
16
14
12
10
8
6
4
2
0
SMALL
Stocks
171%
SMALL
Stocks,
-71%
LARGE
Stocks
LARGE
Stocks
10
20
30
40
50
60
70
80
A: WHAT IS THE FRONTIER IF CANNOT SHORT?

20
18
16
14
12
10
8
6
4
2
0
SMALL
Stocks
171%
SMALL
Stocks,
-71%
LARGE
Stocks
LARGE
Stocks
10
20
30
40
50
60
70
80
PORTFOLIO FRONTIER WITH TWO RISKY

ASSETS
16
14
12
10
Minimum
Variance
8
6
4
2
0
20
25
30
35
40
45
50
MINIMUM-VARIANCE
PORTFOLIO OF RISKY
ASSETS
Portfolio Frontier: Reward-
volatility characteristics of all
feasible portfolio choices for
investors holding LARGE and
SMALL stocks
Minimum-Variance Portfolio:
Portfolio with the lowest
variance
MINIMUM-VARIANCE
PORTFOLIO OF RISKY
ASSETS
Minimum-Variance Portfolio:
The left-most point on the graph
In this example, 94% LARGE
stocks and 6% SMALL stocks
(Standard Deviation = 24.85)

16
EFFICIENT FRONTIER
14
12
Minimum
Variance
10
EFFICIENT FRONTIER
8
6
DOMINATED ASSETS
4
2
DOMINATED ASSETS
0
20
25
30
35
40
45
50
EFFICIENT FRONTIER
OF RISKY ASSETS
Efficient Frontier: Frontier
above the Minimum-Variance
Portfolio
Gives the biggest bang for the
buck
Harry Markowitz wrote about
mean-variance efficient frontiers
in 1950s & won Nobel Prize in
Economics in 1990
DOMINATED ASSETS
Some combinations of LARGE

and SMALL stocks are bad for
investors and should be
avoided
The low part of the curve
Portfolios below the minimum
variance portfolio are dominated
by other portfolios
DOMINATED ASSETS
Can refer to dominated assets

as being inefficient
A portfolio is inefficient if
another portfolio combination
yields a higher average return
with the same standard
deviation of returns.
EXAMPLE OF A
DOMINATED ASSET
(IN THIS EXAMPLE!)
Portfolio consisting only of
LARGE stocks:
Average return of 8%
Standard deviation of 25%
A portfolio of 88% LARGE stocks
and 12% SMALL stocks also has
a standard deviation of 25%, but
offers an average return of 8.8%!
FURTHER ANALYSIS:
ASSIGNMENT 1
The correlation between risky assets
is the key to constructing the reward-
to-volatility tradeoff.
We just completed an efficient
frontier when the correlation between
LARGE and SMALL stocks was 0.4.
What happens if the correlation
between these two assets is
negative?
FURTHER ANALYSIS:
ASSIGNMENT 1
We will map out the reward-to-

volatility tradeoff when the
correlation is -0.8 and calculate
the various key portfolios in this
setting.
REFERENCES

MODULE 1
Portfolio Formation
LESSON 1 - 5
VIDEO 1 - 5.4
Real-World Example of a Dominated Asset
REAL-WORLD
APPLICATION
This May Save You Tens of
Thousands of Dollars!
NO JOKE!
Image by 2bgr8stock, 2009

PAUSE, THINK, AND

ANSWER!

QUESTION: DO YOU SEE

DOMINATED ASSETS
IN THE REAL WORLD?
Any example (maybe in your own portfolio?)
ANSWER: DO YOU SEE

DOMINATED ASSETS
IN THE REAL WORLD?
Any example (maybe in your own portfolio?)
HOW DOMINATED?
EXAMPLE 1
Suppose:
S&P 500 Index Fund A has an
annual expense of 0.05%
S&P 500 Index Fund B has an
Suppose S&P 500 has a 10%

return each year
HOW DOMINATED?
What is difference in wealth

between the two funds after
10 years (in percent terms)?
After 20 years?
After 40 years?
HOW DOMINATED?
Difference after 10 years:
After 20 years:
After 40 years:
HOW DOMINATED?
EXAMPLE 2
Suppose:
S&P 500 Index Fund A has an
Actively-managed large-cap
Fund B has an annual expense
of 1.25%
Suppose S&P 500 and the

large-cap fund each have a
10% return each year
HOW DOMINATED?
EXAMPLE 2
What is difference in wealth
between the two funds after
10 years (in percent terms)?
After 20 years?
After 40 years?
HOW DOMINATED?
Difference after 10 years:
After 20 years:
After 40 years:
REFERENCES
2bgr8stock. 2009. Money-Cash. Retrieved from

https://upload.wikimedia.org/wikipedia/commons/f/f9/Money_Cash.jpg

MODULE 1
Portfolio Formation
LESSON 1 - 5
VIDEO 1 - 5.5
What Weve Learned
WHAT WEVE LEARNED

IN LESSON 1-5
Sharpe Ratio:
Excess return of an asset divided
by its standard deviation
Slope of a reward-to-volatility
chart with that asset and the risk-
free asset
WHAT WEVE LEARNED

IN LESSON 1-5
With two risky assets, one can
also construct a reward-to-
volatility tradeoff
Part of this curve will represent
efficient portfolios
Part will represent dominated
portfolios
Key to constructing reward-to-
volatility tradeoff: correlation
between risky assets

MODULE 1
Portfolio Formation
LESSON 1 - 6
ASSIGNMENT 1 & Discussion:
Portfolio Choice When Change Correlations
VIDEO 1 - 6.1
ASSIGNMENT 1:
LESSON 1-6
OBJECTIVES
Questions for Assignment 1
Discussion of answers for
Assignment 1
Effect of correlation between
assets on portfolios
TWO RISKY ASSETS WITH

VARYING CORRELATIONS:
ASSUMPTIONS
LARGE Stocks
Mean Return: 8%
SMALL Stocks
Mean Return: 15%
What if the correlation is -0.8?

USEFUL SPREADSHEET
FOR ASSIGNMENT 1
QUESTION 1
What will happen with a negative correlation (-0.8) between the

two risky assets? (Use this assumption for all questions.)
Will the variance of the minimum-variance portfolio increase, stay
the same, or decrease when we switch from a correlation of 0.4 to
a negative correlation of -0.8?
Precisely calculate the composition, expected return, and standard
deviation of the minimum-variance portfolio.
QUESTION 2
Will a portfolio of only LARGE stocks continue to be a dominated

asset?
Calculate the composition and expected return of the most
efficient portfolio that yields the highest return, given the level of
risk of LARGE stocks.
QUESTION 3
Achieving an expected portfolio return of 20% requires a portfolio

of 171% in SMALL stocks and -71% in LARGE stocks.
Will you take on more risk with this portfolio when the correlation
between LARGE and SMALL stocks is 0.4 or -0.8? Why do you
think so? Explain in words using economic intuition.
Precisely how much additional portfolio risk will you have to take
(express in terms of change in the portfolio standard deviation)?
GOOD TO BE CURIOUS,
BUT
Image by nist6dh, 2008

DO ASSIGNMENT
ON OWN FIRST!
First do the assignment on your
own and then check out my
discussion!
Feel free to adjust your
responses if you wish before
submitting the assignment.
Please review my discussion
before reviewing/grading
someone elses assignment.
REFERENCES
Nist6dh. 2008. curious-george-original. Retrieved from


MODULE 1
Portfolio Formation
LESSON 1 - 6
VIDEO 1 - 6.2
DISCUSSION OF ASSIGNMENT 1:
TWO RISKY ASSETS WITH

VARYING CORRELATIONS:
ASSUMPTIONS
LARGE Stocks
Mean Return: 8%
SMALL Stocks
Mean Return: 15%
What if the correlation is -0.8?

PORTFOLIO FRONTIER: TWO RISKY ASSETS

( = -0.8)
22
20
18
16
14
12
10
8
6
4
2
0
0
10
20
30
40 50 60 70 80 90 100 110 120 130

PORTFOLIO FRONTIER: TWO RISKY ASSETS

25
Correlation = 0.4
20
SMALL
Stocks
15
Correlation = -0.8
10
5
LARGE
Stocks
0
0
20
40
60
80
100
Correlation = 0.4
120
140
Correlation = -0.8
QUESTION 1
What will happen with a negative correlation (-0.8) between the

two risky assets? (Use this assumption for all questions.)
Will the variance of the minimum-variance portfolio increase, stay
the same, or decrease when we switch from a correlation of 0.4 to
a negative correlation of -0.8?
Precisely calculate the composition, expected return, and standard
deviation of the minimum-variance portfolio.
QUESTION 1 DISCUSSION
Standard deviation of the minimum-variance portfolio
declines substantially when correlation is -0.8 as opposed to
0.4.
Minimum standard deviation: 10.5% (as opposed to 24.85%)
Portfolio: 68% LARGE and 32% SMALL (as opposed to 94% LARGE
and 6% SMALL)
Return of the minimum-variance portfolio increases when the
correlation turns negative
Expected portfolio return is 10.2% (8.4%) when the correlation is -0.8 (0.4)
QUESTION 2
Will a portfolio of only LARGE stocks continue to be a dominated

asset?
Calculate the composition and expected return of the most
efficient portfolio that yields the highest return, given the level of
risk of LARGE stocks.
The LARGE stock portfolio is more dominated when the correlation
is -0.8 than when the correlation is 0.4.
A portfolio of 37% LARGE stocks and 63% SMALL stocks also has
a standard deviation of 25% (same as LARGE stocks), but offers
an average return of 12.4%. (This beats LARGE stocks by 4.4%
per year!)
When the correlation is 0.4: a portfolio of 88% LARGE stocks and
12% SMALL stocks also has a standard deviation of 25%, but
offers an average return of only 8.8%.
QUESTION 3
Achieving an expected portfolio return of 20% requires a portfolio

of 171% in SMALL stocks and -71% in LARGE stocks.
Will you take on more risk with this portfolio when the correlation
between LARGE and SMALL stocks is 0.4 or -0.8? Why do you
think so? Explain in words using economic intuition.
Precisely how much additional portfolio risk will you have to take
(express in terms of change in the portfolio standard deviation)?
A portfolio that is 171% in SMALL stocks and -71% in LARGE

stocks yields an average portfolio return of 20.0% regardless
of the correlation between the two assets.
When the correlation is -0.8, this portfolio has a standard
deviation of 100 (80 when the correlation is 0.4).
Why the difference in portfolio risk?
Why the difference in portfolio risk?
Remember the portfolio variance formula:
Var[rp ] = p2 = w12 12 + w22 22 + 2w1w2 12 1 2

SMALL stocks on average outperform LARGE stocks
Long SMALL and Short LARGE strategy yields positive returns on average
Extremely disparate outcomes when the correlation is negative
Will either yield large positive or large negative returns
WHAT WEVE LEARNED

IN LESSON 1-6
Assignment 1
Effect of correlation between
assets on portfolios

MODULE 1
Portfolio Formation
LESSON 1 - 7
Calculating Efficient Portfolios of Risky Assets
VIDEO 1 - 7.1
Objectives
LESSON 1-7
OBJECTIVES
How to calculate key portfolio
combinations for a set of risky
assets using Excel
Minimum-variance portfolio
Efficient portfolio for a given level
of risk
Portfolio that yields the highest
Sharpe Ratio
LESSON 1-7
OBJECTIVES
How to calculate these portfolios
in the prior example of LARGE
and SMALL stocks
Calculate these portfolios when
risky assets are LARGE, SMALL,
VALUE, and GROWTH funds
based on assumptions using
historical return distributions from
1927-2014
FURTHER PRACTICE
Assignment 2
How a portfolio of US stocks can be
improved with other possible assets
High-engagement learners
Case study: Partners Healthcares
decision whether to add Real
Estate Investment Trusts (REITs)
and Commodities to their portfolio

MODULE 1
Portfolio Formation
LESSON 1 - 7
VIDEO 1 - 7.2
Example 1:
EXAMPLE 1: ASSET
ALLOCATION WITH
TWO RISKY ASSETS
SCOTTS EXCEL FILES
EfficientFrontierLargeSmallExample.xlsx
RETURN-VOLATILITY-
EXAMPLES.XLSX
LARGE Stocks and Treasury
Bills (first tab)
SMALL Stocks and Treasury
Bills (first tab)
LARGE Stocks and SMALL
Stocks (second tab)
RETURN-VOLATILITY-
EXAMPLES.XLSX
Portfolio weights for an asset

vary from -100% to 200%
(need to add to 100% across
assets!)
RETURN-VOLATILITY-
EXAMPLES.XLSX
Expected returns
Standard deviations
Sharpe Ratios
EFFICIENTFRONTIER-
LARGESMALLEXAMPLE.XLSX
Install the add-in Solver to

the Data tab in Excel
Assumptions for LARGE
and SMALL stocks at top
Expected returns
Standard deviations
Correlation between the two
EFFICIENTFRONTIER-
Programmed to compute the

following for a portfolio
Expected return
Variance & standard deviation
Sharpe Ratio
EFFICIENTFRONTIER-
Formula to calculate portfolio variance:

N
Var[rp ] = p2 = wi2 i2 +2 wi w j ij i j
i =1
i =1 j >i
EFFICIENTFRONTIER-
Insert
Assumptions
Portfolio weights (or have

Solver compute these)
EFFICIENTFRONTIER-
Select Solver under the

Data tab to find portfolios
that satisfy certain conditions
Minimum variance
Maximum return given a certain
level of variance
Maximum Sharpe Ratio
EFFICIENTFRONTIER-
Optimizations can be made

with or without restrictions on
shorting an asset
Up to 5 assets can be placed
in the OPTIMIZER
LETS CHECK THAT

THIS WORKS!
Given our prior assumptions
for LARGE and SMALL stocks,
lets calculate:
Efficient portfolio for a given
level of risk
Portfolio with the highest
Sharpe Ratio
EXAMPLE 1: ASSET
ALLOCATION WITH
TWO RISKY ASSETS
EXAMPLE 1:
PORTFOLIO OF TWO
RISKY ASSETS
(ASSUMPTIONS)
Large Stocks
Mean Return: 8%
Small Stocks
Mean Return: 15%
Correlation of 0.4
EXAMPLE 1:
PORTFOLIO OF TWO
RISKY ASSETS
Minimum Variance
94% Large Stocks
6% Small Stocks
Standard Deviation: 24.85
EXAMPLE 1:
PORTFOLIO OF TWO
RISKY ASSETS
Portfolio of LARGE stocks
is a Dominated Asset
Average Return: 8%
Portfolio of 88% LARGE &

12% SMALL Stocks
Average Return: 8.8%
EXAMPLE 1: MINIMUM-VARIANCE PORTFOLIO
EXAMPLE 1: PORTFOLIO THAT DOMINATES LARGE
EXAMPLE 1: MAXIMIZING SHARPE RATIO

MODULE 1
Portfolio Formation
LESSON 1 - 7
VIDEO 1 - 7.3
Example 2:
EXAMPLE 2: ASSET
ALLOCATION WITH
FOUR RISKY ASSETS
NEW EXAMPLE USING

HISTORICAL RETURNS
Use this spreadsheet with
assumptions based on historical
data:
EfficientFrontier-LargeSmall-
ValueGrowth.xlsx

NEW EXAMPLE USING

HISTORICAL ANNUAL
RETURNS, 1927-2014
Large stocks (top 10%)
Small stocks (bottom 10%)
Value stocks (top 10%)
Growth stocks (bottom 10%)

WILLIAM SHARPE ON
ASSUMPTIONS
Although it is always perilous
to assume that the future will
be like the past, it is at least
instructive to find out what the
past was like.
William F. Sharpe, Managing Investment Portfolios: A Dynamic Process

WILLIAM SHARPE
ON ASSUMPTIONS
While results vary from asset class
to asset class and from time period
to time period, experience suggests
that for predicting future values,
historic data appear to be quite
useful with respect to standard
deviations, reasonably useful for
correlations, and virtually useless
for expected returns.
QUESTIONS: 1 OF 4
What is the expected return and standard deviation of a

portfolio that invests 25% in each of the four assets?
Suppose you CANNOT short (portfolio weights CANNOT be
negative for any asset):
Find the portfolio that maximizes expected return given the portfolio
risk of the 25/25/25/25 portfolio. What is the expected return of this
portfolio and what are the portfolio weights in this case?
QUESTIONS: 2 OF 4
Suppose you CAN short at no extra cost (portfolio weights

CAN be negative for any asset):
Find the portfolio of risky assets that maximizes expected return
given the portfolio risk of the 25/25/25/25 portfolio. What is the
expected return of this portfolio and what are the portfolio weights in
this case? How big is the improvement in expected returns?
QUESTIONS: 3 OF 4
Suppose you CANNOT short (portfolio weights CANNOT be

negative for any asset):
What is the expected return and portfolio standard deviation of the
portfolio of risky assets that minimizes portfolio variance? What are the
portfolio weights in this case?
QUESTIONS: 4 OF 4
Suppose you CANNOT short (portfolio weights CANNOT

be negative for any asset):
What is the expected return and standard deviation of the portfolio
of risky assets that maximizes Sharpe Ratio? What are the portfolio
weights in this case?
REFERENCES
William F. Sharpe. 1990. Managing Investment Portfolios: A Dynamic Process, 2nd Edition,
Chapter 7. Retrieved from http://www.investorhome.com/history.htm

MODULE 1
Portfolio Formation
LESSON 1 - 7
VIDEO 1 - 7.4
What Weve Learned
WHAT WEVE LEARNED

IN LESSON 1-7
How to calculate key portfolio
combinations for a set of risky
assets using Excels Solver
Efficient portfolio for a given
level of volatility
Portfolio that yields the highest
Sharpe Ratio
Optimization results are driven by

our assumptions

MODULE 1
Portfolio Formation
LESSON 1 - 8
Calculating More Efficient Portfolios
VIDEO 1 - 8.1
ASSIGNMENT 2:
LESSON 1-8
OBJECTIVES
Questions for Assignment 2
Assignment 2
Effects of other assets on
portfolio formation
WILLIAM SHARPE
ON ASSUMPTIONS
Although it is always perilous
to assume that the future will
be like the past, it is at least
instructive to find out what the
past was like.

WILLIAM SHARPE
ON ASSUMPTIONS
While results vary from asset class
to asset class and from time period
to time period, experience suggests
that for predicting future values,
historic data appear to be quite
useful with respect to standard
deviations, reasonably useful for
correlations, and virtually useless
for expected returns.
ASSET ALLOCATION
WITH FIVE RISKY
ASSETS INCLUDING
GOLD
Large & Small Stocks
Value & Growth Stocks
Gold
EXAMPLE WITH GOLD

Use this spreadsheet with
assumptions based on
historical data 1975-2014:
EfficientFrontier-
LargeSmall-ValueGrowth-
Gold.xlsx
Source: Kenneth R. French Data Library

EXAMPLE WITH GOLD
Large stocks (top 10%)

Small stocks (bottom 10%)
Value stocks (top 10%)
Growth stocks (bottom 10%)
Source: Kenneth R. French Data Library

EXAMPLE WITH GOLD
Source for Gold Prices:

Deutsche Bundesbank Data
Repository
Based on Deutsche Bundesbank Data Repository

QUESTION 1
Suppose you are currently invested 100% in LARGE stocks, and

you CANNOT short (i.e., portfolio weights cannot be negative):
Find the portfolio that maximizes expected return if you want the same risk
of LARGE stocks. What is the expected return of this portfolio and what are
the portfolio weights in this case?
How much are expected returns increased on a monthly basis by switching
from 100% LARGE stocks to this new portfolio?
QUESTION 2
Suppose you CAN short assets at no extra cost (so weights can be
negative). Find the portfolio that maximizes expected return if you
want the same risk of LARGE stocks. What are the portfolio weights?
Which asset do you SHORT in this portfolio? What asset has the biggest increase in
portfolio weight from the CANNOT short to CAN short examples? Why?
Consider the portfolios you found that maximize expected returns subject to having the
same risk as LARGE stocks. What is the benefit in terms of expected returns, in being
able to SHORT assets vs. not being able to SHORT assets? Given this benefit, is
allowing the investor to SHORT important in this example?
QUESTION 3
Suppose you CANNOT short:

What is the expected return and portfolio standard deviation of the portfolio
that maximizes the Sharpe Ratio? What are the portfolio weights?
Does GOLD have any part in this portfolio? If yes, why is GOLD a useful part
of the portfolio? If not, why is GOLD not part of it?
ASSET ALLOCATION
WITH
INTERNATIONAL
STOCKS!
EXAMPLE WITH
INTERNATIONAL
Refer to EfficientFrontier-US-
International.xlsx
Average returns, standard
deviations, & correlations
between securities 7/1990-
2014
US
Japan
Asia Pacific
Europe
QUESTION 4
Suppose you are currently invested 100% in U.S. stocks and you
CANNOT short:
Find the portfolio that maximizes expected return if you want the same risk of
U.S. stocks. What is the expected return of this portfolio and what are the
portfolio weights?
QUESTION 5

What is the expected return and standard deviation of the portfolio that
maximizes the Sharpe Ratio? What are the portfolio weights?
Does JAPAN have any part in this portfolio that maximizes the Sharpe Ratio?
If yes, why is JAPAN a useful part of the portfolio? If not, why is JAPAN not
part of it?
QUESTION 6

Now assume that the expected return for Japanese stocks is 0.96% per
month (the same as Asia Pacific).
What is the expected return and standard deviation of the portfolio that
maximizes the Sharpe Ratio? What are the portfolio weights?
GOOD TO BE CURIOUS,
BUT
nist6dh, 2008
DO ASSIGNMENT
ON OWN FIRST!
First do the assignment on your
own and then check out my
discussion!
Feel free to adjust your
responses if you wish before
submitting the assignment.
Please review my discussion
before reviewing/grading
someone elses assignment.
REFERENCES
William F. Sharpe. 1990. Managing Investment Portfolios: A Dynamic Process, 2nd Edition,
Chapter 7. Retrieved from http://www.investorhome.com/history.htm
Deutsche Bundesbank Data Repository. Retrieved from
https://www.quandl.com/data/BUNDESBANK/BBK01_WT5511-Gold-Price-USD)
nist6dh. 2008. curious-george-original. Retrieved from

MODULE 1
Portfolio Formation
LESSON 1 - 8
VIDEO 1 - 8.2
DISCUSSION OF ASSIGNMENT 2:
LARGE/SMALL/VALUE/GROWTH/GOLD
LARGE stock assumptions: standard deviation = 4.30%, avg. return
= 1.01%, Sharpe Ratio = 0.142
Same risk as LARGE
stocks
(no shorting)
Same risk as LARGE

stocks
(shorting)
Portfolio with max

Sharpe Ratio
(no shorting)
LARGE weight
22%
111%
0%
SMALL weight
11%
30%
15%
VALUE weight
48%
31%
75%
GROWTH weight
0%
-86%
0%
GOLD weight
19%
14%
10%
Portfolio Expected Return
1.20%
1.25%
1.39%
Portfolio Sharpe Ratio
0.185
0.198
0.189
Assuming no shorting is allowed, a portfolio containing a mix of

LARGE (22%), SMALL (11%), VALUE (48%), and GOLD (19%)
dominates a LARGE-only portfolio (same standard deviation, but
higher return)
Boosts the average return by 0.19% per month relative to the LARGE-only
portfolio
GROWTH stocks have zero weight
= 1.01%, Sharpe Ratio = 0.142
Same risk as LARGE
stocks
(no shorting)
Same risk as LARGE

stocks
(shorting)
Portfolio with max

Sharpe Ratio
(no shorting)
LARGE weight
22%
111%
0%
SMALL weight
11%
30%
15%
VALUE weight
48%
31%
75%
GROWTH weight
0%
-86%
0%
GOLD weight
19%
14%
10%
1.20%
1.25%
1.39%
0.185
0.198
0.189
Assuming the ability to short assets only marginally improves the

portfolio return, this strategy involves a gigantic allocation to
LARGE stocks and a big short of GROWTH stocks.
This combination reflects LARGE beating GROWTH by 0.06% per month on
average with a very high correlation between the two assets (0.93), but the
difference in returns is not large enough to matter very much.
= 1.01%, Sharpe Ratio = 0.142
Same risk as LARGE
stocks
(no shorting)
Same risk as LARGE

stocks
(shorting)
Portfolio with max

Sharpe Ratio
(no shorting)
LARGE
22%
111%
0%
SMALL
11%
30%
15%
VALUE
48%
31%
75%
GROWTH
0%
-86%
0%
GOLD
19%
14%
10%
1.20%
1.25%
1.39%
0.185
0.198
0.189
Assuming there is no shorting, the portfolio of risky assets that

maximizes the Sharpe Ratio (i.e., the Tangency portfolio) contains
75% VALUE stocks, 15% SMALL stocks, and 10% GOLD.
High allocation to VALUE stocks: high average return & high Sharpe Ratio
Assuming there is no shorting, the portfolio of risky assets that

maximizes the Sharpe Ratio (i.e., the Tangency portfolio) contains
75% VALUE stocks, 15% SMALL stocks, and 10% GOLD.
Gold is part of portfolio: even though its return is much lower than the
stocks on average, it does offer a higher return on average than the risk-free
rate
The zero correlation with the various stocks provides some stability to the
overall portfolio that is worthwhile
EXCEL SOLVER INPUTS FOR THE 1ST COLUMN
EXCEL SOLVER INPUTS FOR THE 2ND COLUMN
EXCEL SOLVER INPUTS FOR THE 3RD COLUMN
US/JAPAN/ASIA PACIFIC/EUROPE
U.S. stock assumptions: standard deviation = 4.34%, avg. return =
0.89%, Sharpe Ratio = 0.150
Same risk as U.S.
stocks
(no shorting)
Portfolio with max

Sharpe Ratio
(no shorting)
max Sharpe Ratio,

Japan = 0.96%
(no shorting)
U.S. weight
93.7%
86.9%
69.4%
Japan weight
0.2%
0%
29.9%
Asia Pacific weight
6.1%
13.1%
0.7%
0%
0%
0%
0.89%
0.90%
0.91%
0.150
0.151
0.163
Europe weight
QUESTIONS 4 & 5 DISCUSSION
For someone already investing in U.S. stocks, the ability to

diversify by adding Japanese, Asian Pacific, and European funds
does little to improve portfolio performance.
Maximum-Sharpe-Ratio portfolio: 87% in the U.S. stocks
Japanese stocks excluded from maximum-Sharpe Ratio portfolio because of
historically poor performance
If we assume that Japan will have the same expected return as

Asia Pacific, it becomes 30% of the maximum-Sharpe-Ratio
portfolio (Asia Pacific is less than 1% of the portfolio).
Japans relatively low correlations with the other indices make it a valuable
addition to the portfolio under the higher-return assumption.
WHAT WEVE LEARNED

IN LESSON 1-8
Assignment 2
Effects of other assets on
portfolio formation

MODULE 1
Portfolio Formation
LESSON 1 - 9
Module 1 Review
VIDEO 1 - 9
Module 1 Review
MODULE 1
Johnivan Darby

Arithmetic
Average
Standard
Deviation
3.5%
3.1%
5.3%
7.8%
11.9%
20.4%
19.0%
39.4%
Annual Returns (%)

SMALL STOCKS
160
140
120
100
80
60
40
20
0
-20
-40
-60
1920
1930
1940
1950
1960
US Stock Market
1970
1980
1990
2000
2010
2020
US Small Stocks (bottom decile)

16
EFFICIENT FRONTIER
14
12
Minimum
Variance
10
EFFICIENT FRONTIER
8
6
DOMINATED ASSETS
4
2
DOMINATED ASSETS
0
20
25
30
35
40
45
50
WHAT WEVE LEARNED

IN MODULE 1
U.S. stock market has
outperformed U.S. Treasury bills
by 8% per year on average, while
small stocks have outperformed
the market by a sizeable margin
Wise portfolio formation can
reduce risk
Risk aversion will determine your
asset allocation
WHATS AROUND THE BEND?
Richard Webb, S abre-Roads.org, CC B Y-SA 2.0

MODULE 2: MOTIVATING, EXPLAINING, &

IMPLEMENTING THE CAPITAL ASSET PRICING
MODEL (CAPM)
REFERENCES
Johnivan Darby. 2015. Wrap.

Richard Webb. 2009. Something interesting around the bend. Retrieved from
http://www.sabre-
roads.org.uk/wiki/index.php?title=File:Something_interesting_around_the_bend_-
_Geograph_-_1502288.jpg

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